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Hot Hands, Hot Picks

Profit with seven pros as they lay their cards on the table.

June 30, 2006

How do you pick a good stock? Ask that question of a random group of investors and you're likely to get a bunch of random answers. But ask a carefully chosen group of highly successful stock pickers and you'll get a great education about what is really important in investing -- not to mention some terrific stock picks.

That's exactly what we did. We sought out seven veteran investors with superior short- and long-term records and asked them to share their best investing ideas with us. Each has a different approach, so it is worth noting when some of them arrive at the same conclusions. Cement, home-building and energy stocks, for example, came up more than once. And it should come as no surprise that these veterans are willing to buy in sectors that other pros shun or ignore. That's where the best opportunities lie.

Ride overseas tailwinds

Small company or large, growth or value, Rudolph-Riad Younes makes investing overseas seem easy. Younes, who grew up in Lebanon and is based in New York City, has clobbered the competition during his 11-year tenure at Julius Baer International. Over the past decade, the fund returned 17% annualized to May 1 -- about twice the average return of all diversified international-stock funds.

Younes, who runs the fund with Richard Pell, thinks big trends first. He looks for businesses that benefit from positive forces in the industries in which they operate and that don't face "headwinds." Younes, 44, wants stocks that he can hold for five to ten years, as well as other medium-term investments that are selling for less than the company's fundamental value.

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Younes is keen on Homex Development, Mexico's leading homebuilder. To help alleviate an acute housing shortage, the Mexican government has begun providing subsidized loans to its lower- and middle-class citizens to purchase homes. He thinks the company can generate 15% annual earnings growth over the next five years. The stock sells at 15 times this year's estimated profits (all share prices are to May 15).

Younes also likes Norway's Norsk Hydro. While most major oil companies struggle to boost output, Norsk is ramping up by nearly 10% a year. Moreover, Younes thinks Norsk Hydro has a good shot at partnering with Russian natural-gas giant Gazprom to develop a huge field in the Barents Sea. The stock trades at 13 times the average of analysts' 2006 estimates.

In searching for companies with strong "tailwinds," Younes seeks opportunities in consolidating industries with relatively few players. He sees a lot of potential in cement, in which the ten biggest companies hold 55% of the global market, up from less than 20% in the 1980s. His favorite is France's Lafarge, the worldwide leader.

The liquor industry, ruled by four global companies, is even more concentrated. His pick is Diageo, the British purveyor of such brands as Smirnoff vodka and Johnnie Walker whisky. As people age, they tend to switch to hard liquor, and Younes thinks Diageo could generate double-
digit earnings growth the next few years. The stock trades at 17 times estimated earnings for the fiscal year ending in June 2007 and yields 2.5%.
--Andrew Tanzer

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Focus on a few

When Joel Greenblatt speaks, investors listen. Since founding Gotham Capital in 1985, hedge-fund maestro Greenblatt says he's returned an astonishing 40% a year. He agreed to discuss two of the five stocks in his super-concentrated portfolio with us.

In his recently published The Little Book That Beats the Market (Wiley, $20), Greenblatt describes a "magic formula" for picking stocks. In brief, he seeks companies with high returns on capital and high earnings yields (profits divided by stock price); the formula uncovers high-return businesses with undervalued stocks. Greenblatt, 48, offers a clue about what the formula is uncovering these days: "This is the first time in 25 years that most of the bargains we're finding are in large-cap, quality businesses."

American Express certainly fits the profile. The stock sells at 18 times projected earnings for 2006, implying an earnings yield of nearly 6% (think of this as what a stock would yield if all profits were paid out as dividends). Because AmEx is a financial stock, Greenblatt focuses on return on equity -- in excess of 30% -- instead of return on capital. (Financial firms often borrow a lot of money to lend out, blowing up assets and making total capital less meaningful than the equity portion of the balance sheet.)

Greenblatt thinks New York-based AmEx can sustain 12% to 15% earnings growth for years to come, principally because of its powerful credit-card business. The spinoff last year of Ameriprise Financial, a fund-management business, should boost AmEx's ROE -- something Greenblatt thinks investors don't yet appreciate. He says the stock should sell at $75 to $80 within two years.

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Greenblatt's second pick is AutoZone, a leading auto-parts retailer. AutoZone, which is headquartered in Memphis and has more than 3,600 stores, is expanding rapidly. Greenblatt figures that the company can earn a towering 50% pretax return on capital on each new store it opens. He projects that AutoZone will earn more than $9 a share in its fiscal year ending August 2008 and that the stock could fetch $140 a share by then. --Andrew Tanzer

Know the value of cash

To understand Bruce Berkowitz, it helps to know his roots. As a youngster in Chelsea, Mass., he toiled in his parents' grocery store. "It was stamped into my brain that cash comes in, and cash goes out to stock shelves, pay wages, keep the place painted and clean," he recalls. "What was left over were real owner earnings."

Borrowing the retail analogy, Berkowitz focuses on free cash flow -- his concept of owner earnings -- when analyzing stocks. Free cash flow is essentially earnings plus depreciation and other noncash charges minus the capital outlays needed to maintain a business. In addition, Berkowitz, 48, searches for outstanding managers who have substantial wealth tied up in their companies and who treat public shareholders fairly. The formula works: Over the past five years, Fairholme fund, which he co-manages with Larry Pitkowsky and Keith Trauner, gained 15% annualized, compared with 3% for Standard Poor's 500-stock index.

A disciple of Warren Buffett, Berkowitz is bullish on Berkshire Hathaway. He believes the run-up in short-term interest rates will generate at least $1.5 billion in additional profit for Berkshire's $45 billion cash pile. A recent change in federal law allows Buffett's Omaha-based holding company to invest some of its huge, low-cost insurance float (cash flow from premiums) in higher-yielding utilities. And a shakeout of property-and-casualty insurers will strengthen the position of Buffett's rock-solid insurance units. You can buy one Berkshire B share for a mere $2,980.

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Berkowitz thinks he's backing another winner in Charlie Ergen, founder of EchoStar Communications, the satellite-TV network. When the Englewood, Colo., company surpassed 11 million paid subscribers last year (it now has 12 million), it started to generate free cash flow.

These days, it seems no portfolio is complete without an oil-and-gas stock. Berkowitz likes Canadian Natural Resources for its large-scale development projects, including some in the oil sands of Alberta. "We think the projects will provide economic returns even if the price of oil falls to $28 a barrel," says Pitkowsky, who believes the company can double its oil production within six years. Because the production build-up will take time, this is a stock for patient investors. --Andrew Tanzer

Go for bargains

Although John Buckingham considers himself a value investor, he's hardly dogmatic about it. If they're cheap, he'll buy growth stocks. And technology stocks typically account for 40% of the holdings of the Al Frank fund, which he has managed since 1998. "I like to go where the bargains are," says Buckingham. Over the past year his fund gained 33%, and over the past five it returned an annualized 16%.

American Software, a tiny supplier of software and services to businesses, is a good example of an overlooked, cash-rich tech stock that Buckingham favors. Although the Atlanta-based company has shown little earnings growth lately, it is profitable and holds $2 a share in cash. Moreover, American holds an 88% stake in Logility, a software maker whose shares nearly doubled over the past year. That, plus American's positive cash flow and a 4% dividend yield, makes the stock attractive.

Like other value investors, Buckingham has a keen eye for out-of-favor stocks. Homebuilder D.R. Horton is one of them. Although sales and profits have grown for 28 straight years, shares of the Fort Worth, Tex., company have sunk as investors have grown pessimistic about the housing market. Now the stock trades for just six times this year's expected earnings of $5.22 per share. "There are not many companies I know of that have a 28-year winning streak, yet are trading at a P/E of less than 7," says Buckingham.

Buckingham has also been buying Lyondell Chemical as many other investors have fled. Rising prices for products based on oil, a key raw material, have dampened enthusiasm for chemical makers, and a recent adverse court ruling in a lead-paint case further depressed the shares. So Lyondell trades for a mere seven times expected 2006 profits of $3.38 per share. But Buckingham thinks others are overlooking the ability of chemical makers to pass on rising energy costs by raising prices. The stock yields 4%. --David Landis

Spot growth early

You've probably never heard of Managers AMG Essex Small/Micro Cap Growth or its manager, Nancy Prial. But since Prial launched the fund in June 2002, it has been on a tear. It gained 66% in 2003, 16% in '04, 14% last year and 19% in the first four months of '06. As the fund's name suggests, Prial, a 20-year industry veteran, invests in small companies -- those with market values of $50 million to $1.5 billion. Her objective is to "uncover growth early, and in places investors aren't looking yet."

One favorite is Blackboard, the largest maker of Web-based educational software. The Washington, D.C., company sells mainly to universities; instructors use its program to post notes, assign homework and deliver grades online. "Blackboard is quickly becoming a must-have for universities," says Prial. The company expects sales to rise 23% to 26% in 2006. The stock has almost doubled since Blackboard went public in 2004.

Prial is also high on Christopher Banks, a Minneapolis retailer that operates 711 stores that cater to women age 40 and older. Sales have been sluggish the past few years because of uninspiring merchandise. But new management is "focusing on improving, streamlining, and getting rid of the large, bulky sweaters the stores are known for," says Prial. The stock trades for 25 times estimated earnings of $1.01 per share for the year that ends in February 2007.

Prial finds opportunities in places that growth investors often ignored in years past. For instance, she's enamored of Bucyrus International, a Bucyrus, Ohio, company that makes large-scale excavation machinery used to mine coal, copper and iron ore. Benefiting from strong demand for commodities around the globe, nearly three-fourths of sales are overseas. "We've had a 30-year downturn in equipment, and now the replacement cycle is kicking in," says Prial.
The stock trades for 26 times estimated 2006 profits of $2.12 per share. --Katy Marquardt

Spot growth early, part deux

Don Hodges's strategy is deceptively simple. He likes to buy companies with improving earnings growth. He's not the only one, but Hodges has a knack for beating others to the punch. In 2004, he paid $35 for shares of Burlington Northern Santa Fe, the top holding in the Hodges fund. The railroad's shares now trade at $80. So his current enthusiasm for deep-sea oil drillers, homebuilders, and cement and steel companies is worth noting. His 14-year-old fund, co-managed since 1999 with son Craig, returned 42% over the past year and an annualized 19% over the past five years.

Two of Hodges's favorite drillers, Ensco International and Transocean, have skyrocketed in price over the past two years. But still-rising oil prices and a worldwide shortage of drilling rigs should allow both firms to substantially boost day rates for existing rigs when their near-term contracts expire, he says. Both companies could deliver earnings growth in excess of 40% annually over the next five years. "This has always been considered a cyclical industry, but I think the cycle is going to last a lot longer this time," Hodges says.

Among cement makers, Hodges's favorite is Texas Industries. The Dallas company accounts for about 30% of the cement sold in Texas and also generates significant sales in California. Fear of a housing slowdown has dampened enthusiasm for cement stocks, but Hodges says booming highway and public-works construction should keep demand high. Analysts see TI's profits jumping 38% in the fiscal year that ends May 2007.

Hodges was an early owner of Chaparral Steel, which was spun off from Texas Industries last July at $18 a share. Although it's nearly four times the price, Hodges still likes it. Bankruptcies and consolidation have removed many weak companies, leaving the survivors with the power to raise prices as China, India and other emerging markets drive up demand. Shares of Chaparral, in Midlothian, Tex., still trade for less than ten times expected earnings of $6.85 per share for the fiscal year ending May 2007. --David Landis

Play off the big picture

Ken Heebner is nothing if not unconventional. Heebner, 65, bets heavily on a relatively small number of stocks that he believes are poised for takeoff. He chooses stocks based on the big economic picture or on his assessment of sectors, and he is quick to jettison stocks that disappoint. Few mortals can succeed by running money this way. Heebner does. His CGM Focus fund gained an annualized 24% over the past five years, clobbering the SP 500 by 21 percentage points a year. Over the past year, the fund soared 42%. Heebner's long-term record is also exceptional. His CGM Capital Development gained an annualized 17% over the past 30 years, four percentage points a year better than the SP.

Heebner plays his cards close to the vest, so he won't talk about current strategy. But based on Focus's most recent report, at the end of 2005, and its performance in the first four months of 2006, it's safe to say he is still betting big on natural-resources stocks. Focus's largest position at year-end was copper producer Phelps Dodge. Fierce demand from developing nations, particularly China, has lifted copper prices to record highs. Analysts expect Phoenix-based Phelps, one of the world's largest copper producers, to earn $11.56 per share in '06. On that basis, the P/E is just 8.

Another big Focus holding is SunCor Energy, a nearly pure play on the extraction of oil from western Canada's energy-rich Athabasca oil sands. SunCor's oil-sands leases hold about 14 billion barrels of oil. The Calgary-based company's ambitious goal: to boost its daily extraction from 260,000 barrels to more than 500,000 by 2012. SunCor trades at 20 times estimated 2006 earnings of $4.21 per share.

Even Heebner diversifies a little, as evidenced by his big holding in Station Casinos. A beneficiary of Las Vegas's booming economy, Station owns eight casinos that cater to Vegas locals (none are located on the tourist-filled Strip). This is a profitable niche -- one with barriers to entry, thanks to a 1997 Nevada law that limits the amount of off-Strip land that can be used for casinos. Station scooped up most of the casino-zoned land, giving it a dominant position in catering to Vegas residents. Station shares trade at 29 times estimated 2006 profits of $2.69 per share. --Katy Marquardt

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